Capital Formation Simply Means the Addition in the Stock of Capital Goods

7/28/2019 Capital Formation Simply Means the Addition in the Stock of Capital Goods

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Capital formation simply means the addition in the stock of capital goods. If the stock of capital increases

over time, it is called capital accumulation or capital formation. When investment increases, capital goods

also increase which is termed as capital formation.

According to Todaro and Smith, Capital accumulation is increasing a countrys stock of real capital (net

investment in fixed assets). Capital accumulation occurs if some portion of present income is saved and

invested in order to increase output and income in future. New factory, machinery, equipments and

materials increases the stock of the physical capital of a country. It is thus obvious that addition to the

stock of capital goods like machinery, tools, and equipments is known as capital formation.

In modern time capital formation includes not only the increase in the stock of physical capital but also the

increase in capital. Productive investments embodied in human persons are known as human capital.

The expenses made on education, health, technical training, and nutrition to increase the productivity and

morale of men are also counted as capital formation. Like physical capital, human capital also increases a

countrys productive capacity. H.W. Singer thus rightly remarks, C apital formation should include both

physical goods such as plant, equipment, machinery and non-physical goods such as high level of

education, health, scientific tradition and research.

In brief, capital formation denotes the increase in the stock of both physical and human capital in the

country. Any further increase in its stock of capital can be achieved only by forgoing the satisfaction of

some present wants. Hence, the quantity of goods consumed in a period must be less than the totalproduced if capital formation is to take place. So: capital formation can be expressed as:

Capital formation = Production Consumption

Capital Formation Process

Capital formation process has following three stages. which are described below:-

1. Increasing Savings

Capital formation depends on saving. According to J.M. Keynes Saving is the excess of income over

consumption expenditure To be more precise, saving is a part of income that is not spent on current


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consumption. If consumers spend their entire inc omes on consumers goods, there could be no

accumulation of capital goods. If, on the other hand, consumers decide to save part of their incomes,

countrys resources can be devoted to making capital goods. Thus, the production of capital goods

depends on saving as shown in the following chart:-

In economics, the term investment is used to mean the actual production of capital goods. S0 it can be

said that investment depends on saving.

Determinants of Savings

Capital accumulation depends on volume of saving. The volume of saving in turn depends broadly on

three factors power to save, will to save and facilities to save. These factors, which govern the

accumulation of capital, can be explained as follows:

Power to Save

The power to save depends mainly on following factors:

Level of Income

The level of income is the most important determinant of saving. Greater the level of income, greater is

the volume of saving and vice versa. It is because saving is the excess of income over expenditure.

Sa ving is possible only if ones income is greater than expenditure. If a man can only make both ends


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meet, he will have no saving, the surplus of income may accrue either from increased production or from

more economical consumption.

Distribution of Income

The greater the inequality in the distribution of income, greater will be saving. If there is more equal

distribution of income, more of the income will be consumed. Because, it is believed that rich people have

higher prosperity to save whereas the poor people have higher prosperity to consume.

Government Policy

Saving also depends on tax policy of the government. Higher rate of taxes leave less disposable income

with the people. Hence, higher the rate of taxes, less will be saving and vice versa. Similarly if the

government policy is to encourage investments and levy only reasonable taxes, the volume of saving will

be high.

Will to Save

More surplus of income does not lead to the creation of capital. There must also be a willingness to save

on the part of the people. The will to save depends on following factors, which are called subjective

considerations, or personal factors:

Foresight

The prudential consideration or foresight makes men to save from their current income. People save part

of their income for unforeseen contingencies, such as unemployment, illness. Men also save to smoothen

consumption over lifetime or for old age or leave something to their dependents. Hence, higher the

foresight of people, higher is the saving for rainy days.

Family Affection


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The greater family affection also leads to saving. People with greater family affection have strong will- to-

save. It is because they save to strengthen the sound economic position of their family. They also save

for their children s marriage, education etc.

Social and Political Esteem

The social and political esteem depends to some extent on ones wealth. Hence, the desire to have

respect, influence and power in the society encourages people to save.

Rate of Interest

The economic consideration like the desire to earn interest also leads to-an accumulation of capital.

Generally, higher the rate of interest, greater is the inducement to save.

Temperament

For some people saving is a habit. Just as they cannot live without eating and drinking, they cannot

probably live without saving. For example, misers save for its own sake.

Facilities to Save

A man having willed to save would like to save only if there are facilities to save in the country. The

important facilities to save, which are called objective considerations, are as follows:

Peace and Security

People like to save more only if they are certain that their saving can be kept safely. People must be

assured that their saving will not be stolen or robbed or snatched by the government into the form of high

taxes. S0 there must be peace and security for higher rate of saving. The peace and security also assure

greater return from investments.


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Investment Opportunities

People can use their money to productive purposes only when facilities for investment are available. If there is absence of investment opportunities, people will not be able to invest their saving. Hence, they

will not find it worthwhile to save.

Development of financial Institutions

The facility to save is conditioned by the development of financial institutions like banks, finance

companies. If there are more financial institutions there are more facilities to save. Hence saving will be

higher. Savings kept with the financial institutions provide security, liquidity and income. The high rate of

saving in Japan in past was due to the development of financial institutions.

Stability in Value of Money

The value of money should remain stable over a period of time for larger savings. It is because if the

value of money keeps on fluctuating people will be discouraged to save. Similarly, people will save more

only if there exist a means of storing value for long periods without any loss.

2. Mobilization of Savings

The second stage of capital formation is the mobilization of available savings. The act of mobilizing

savings is done by the financial institutions such as commercial banks, finance companies, insurance

companies, cooperative societies and so on. These institutions collect deposits from general public.

These institutions provide security to savings, provide liquidity to savers, and also provide income in the

interest. Due to this, people like to save through financial institutions. These institutions mobilize thesavings collected toward productive investments. Saving and investment are done by different classes of

people. Financial institutions act as intermediaries between savers and investors. This leads to the

increase in capital formation.

3. Investment of Savings


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The third stage of capital formation is the investment of savings. Investment creates capital goods. The

act of investment is done by entrepreneurs. Therefore, a large number of bold and skilled entrepreneurs

are indispensable for increasing capital formation in the country. Entrepreneurs acquire surplus funds

from financial institutions and the capital market and make productive investment in various types of

industries. Investments create and increase machinery and equipments. This leads to the increase in the

national income of the country.

According to Schumpeter to perform the investment function well, entrepreneurs need technical

knowledge to produce new goods. Similarly, sufficient amount of bank credit should be available in order

to acquire factors of production. Besides, transport, communication, electricity, educated manpower

should also be available adequately for the promotion of investment. Countrys socioeconomic

environment should also be conducive for the development of entrepreneurship.

Capital formation is regarded as a key to economic development. It is because capital formation leads to

an increase in the supply of machinery, equipments, plants, and also an increase in human capital. This

increases production and productivity in an economy. This in turn increases employment opportunities

and standard of living of people. Thus, capital formation is considered very important.

Chart below shows capital formation process.

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Capital Formation Simply Means the Addition in the Stock of Capital Goods